Question 11.10.5: Lawrence Ltd operates a system of flexible budgets and the f...
Lawrence Ltd operates a system of flexible budgets and the flexed budgets for expenditure for the first two quarters of year 3 were as follows:
Flexed budgets – quarters 1 and 2
Quarter 1 Quarter 2
Activity
Sales units 9,000 14,000
Production units 10,000 13,000
Budget cost allowances £ £
Direct materials 130,000 169,000
Production labour 74,000 81,500
Production overhead 88,000 109,000
Administration overhead 26,000 26,000
Selling and distribution overhead 29,700 36,200
Total budget cost allowance 347,700 421,700
Despite a projected increase in activity, the cost structures in quarters 1 and 2 are expected to continue during quarter 3 as follows:
(a) The variable cost elements behave in a linear fashion in direct proportion to volume. However, for production output in excess of 14,000 units the unit variable cost for production labour increases by 50 per cent. This is due to a requirement for overtime working and the extra amount is payable only on the production above 14,000 units.
(b) The fixed cost elements are not affected by changes in activity levels.
(c) The variable elements of production costs are directly related to production volume.
(d) The variable element of selling and distribution overhead is directly related to sales volume.
You are required to prepare a statement of the budget cost allowances for quarter 3, when sales were 14,500 units and production was 15,000 units.
If you divide each cost figure by the relevant activity figure, you will find that the only wholly variable cost is direct material, at £13 per unit.
You can also see that the only wholly fixed cost is administration overhead since this is a constant amount for both activity levels, £26,000.
For the remaining costs you will need to use the high–low method to determine the fixed and variable elements
Production labour
Production, units £
Quarter 2 13,000 81,500
Quarter 1 10,000 74,000
Change 3,000 7,500
Variable cost per unit = \frac{£7,500}{3,000} = £2.50 per unit
Fixed cost = £ 81500 – (£ 2. 50 × 13,000) = £49,000
Production overhead
Production, units £
Quarter 2 13,000 109,000
Quarter 1 10,000 88,000
Change 3,000 21,000
Variable cost per unit = \frac{£21,000}{3,000} = £7 per unit
Fixed cost = £109,000 – (£7 × 13,000) = £18000
Selling and distribution overhead
Note that the example data says that selling and distribution overhead is related to sales volume.
Sales, units £
Quarter 2 14,000 36,200
Quarter 1 9,000 29,700
5,000 6,500
Variable cost per unit = \frac{£6,500}{5,000} = £1.30 per unit
Fixed cost = £36,200 – (£1.30 × 14,000) = £18,000
We can now prepare a statement of the budget cost allowances for quarter 3.
Quarter 3
Budget cost allowance
£ £
Direct material (15,000 units × £13) 195,000
Production labour:¹
Fixed 49,000
Variable up to 14,000 units (14,000 × £2.50) 35,000
Variable above 14,000 units (1,000 × £3.75) 3,750
87,750
Production overhead:
Fixed 18,000
Variable (15,000 × £7) 105,000
123,000
Administration overhead: fixed 26,000
Selling and distribution overhead:
Fixed 18,000
Variable (14,500 × £1.30)² 18,850
36,850
Total budget cost allowance 468,600
Note 1: The unit variable cost for production labour increases by 50 per cent for production over 14,000 units.
Note 2: The flexible budget allowance for selling and distribution overhead must be based on the sales volume of 14,500 units